Trade Linkage and Transmission of Geopolitical Risks: Evidence from the Peace Progress in 2018

Abstract

Purpose - Using unexpected changes in geopolitical tensions on the Korean peninsula as a quasinatural experimental setting, we examine whether and how geopolitical risks travel across borders through firm-level imports and exports linkages. We also test whether the effects are driven by either imports or exports and assess whether firms can effectively hedge themselves against geopolitical risks. Design/methodology - We focus on a series of unanticipated geopolitical events taken place in Korea in 2018. Making use of the shocks to geopolitical climate, we identify five milestone events toward peace talks. We employ the event studies methodology. We examine heterogenous firm-level stock price reactions around key event dates depending on firms’ exposure to geopolitical risks. As a measure of firms’ exposure to geopolitical risks in Korea, we utilize a text-based measure of firm-level trade links. When a firm announces and discusses its purchase of inputs from Korea or sales of outputs to Korea in their annual disclosure filings, we define a firm to have a trade relationship with Korea and have exposure to Korean geopolitical risks. Similarly, we use a measure of a firm’s hedging policies based on a firm’s textual mention of the use of foreign exchange derivatives in their annual disclosure. Findings - We find that U.S. firms that have direct trade links to Korea gained significantly more value when the intensity of geopolitical risks drops compared to firms without such trade links to Korea. The effects are pronounced for firms purchasing inputs from or selling outputs to Korea. We find that the effectiveness of foreign exchange hedging against geopolitical risks is limited. Originality/value - We document the international transmission of geopolitical uncertainty through trade linkages. Export links as well as import links serve as important nexus of transmission of geopolitical risks across borders. Hedging strategies involving foreign-exchanges derivatives do not seem to insulate firms again geopolitical risks. With the recent movements of localization and reshuffling of the global value chain, our results suggest a significant impact of geopolitical risks in Korea on the construction of the global value chain.